About this Author

College chemistry, 1983

The 2002 Model

After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases.
To contact Derek email him directly: derekb.lowe@gmail.com
Twitter: Dereklowe

April 11, 2011

R&D Is For Losers?

Posted by Derek

Now here's a piece that I'm looking for good reasons to dismiss. And I think its author, Jim Edwards, wouldn't mind some, too. You've probably heard that Valeant Pharmaceuticals is making a hostile offer for Cephalon, a company that's dealing with some pipeline/patent problems (and, not insignificantly, the recent death of their founder and CEO).

Valeant's CEO, very much alive, is making no secret of his business plan for Cephalon should he prevail: ditch R&D as quickly as possible:

“His approach isn’t one that most executives in the drug business take,” (analyst Timothy) Chiang said in telephone interview last week. “He’s even said in past presentations: ‘We’re not into high science R&D; we’re into making money.’ I think that’s why Valeant sort of trades in a league of its own.”

. . .Pearson’s strategy and viewpoint on research costs have been consistent. When he combined Valeant with drugmaker Biovail Corp. in September, he cut about 25 percent of the workforce, sliced research spending and established a performance-based pay model tied to Valeant’s market value.

“I recognize that many of you did not sign up for either this strategy or operating philosophy,” Pearson wrote in a letter to staff at the time. “Many of you may choose not to continue to work for the new Valeant.”

Valeant does, in fact, make plenty of money. But my first thought (and the first thought of many of you, no doubt) is that it's making money because other people are willing to do the R&D that they themselves are taking a pass on. In other words, there's room for a few Valeants in the industry, but you couldn't run the whole thing that way, because pretty soon there'd be nothing for those whip-cracking revenue-maximizing managers to sell. Would there?

But we don't have to go quite that far. Edwards, for his part, goes on to wonder (as many have) whether the drug industry should settle out into two groups: the people that do the R&D and the people that sell the drugs. This idea has been proposed as a matter of explicit government policy (a nonstarter), but short of that, has been kicked around many times. Most of the time, this scheme involves smaller companies doing the research, with the big ones turning into the regulatory/sales engines, but maybe not:

If you agree that there ought to be a division of labor in the pharma business — that some companies should develop drugs and then sell those products to the companies that have the salesforces to market them — then this says some interesting things about recent corporate strategy moves among the largest companies. Pfizer (PFE) is downsizing its R&D operations and Johnson & Johnson (JNJ) is said to be on the prowl for a ~$10 billion acquisition.

Merck, on the other hand, is doubling down on its own research and stopped giving Wall Street guidance in hopes of lessening the scrutiny paid to its R&D expense base..

The heralds of this restructuring of the industry haven't quite called it this way, but instead splitting from each other, perhaps the big companies will divide into two camps (Merck vs. Pfizer) and the smaller ones, too (Valeant vs. your typical small pharma). Prophecy's not an exact science - Marx thought that Germany and England would be the first countries to go Communist, you know.

For my part, I think that there are game-theory reasons why a big company won't explicitly renounce R&D. As it is, a big company can signal that "Yes, we'd like to do a deal for your drug (or your whole company), but you know, there are other things for us to do with the money if this doesn't work out." But if you're only inlicensing, then no, there aren't so many other things for you to do with the money. Everyone else can look around the industry and see what's available for you to buy, and thus the price of your deals goes up. You have no hidden cards from your internal R&D to play (or to at least pretend like you're holding). This signaling, by the way, is directed to the current and potential shareholders as well: "Buy our stock, because you never know what our brilliant people are going to come up with next". That's a more interesting come-on line than "Buy our stock. You never know who we're going to buy next." Isn't it?

And that's a separate question from the even bigger one of whether there are enough compounds out there to inlicense in the first place. No, I think that big companies will hold onto their own R&D in one form or another. But we'll see who's right.

Did you purposefully leave out the fact that Valeant's CEO is a McKinsey alumni ? ;)

Indeed, that way of doing business is still viable now, while there are still a number of small companies doing R&D and willing to get bought out by salesmen companies like Valeant. To a certain point, that's what Big Pharma companies have also been doing with their biotechs buyout (eg Pfizer and Sugen). But as you point out, it certainly isn't viable for drug development in the long term, as at some point they'll run out of things to buy.

The quote attributed to Margaret Thatcher is "The trouble with Socialism is that eventually you run out of other people's money." The trouble with Valeant's model is that eventually you'll run out of other people's ideas.

Your idea about 2 types of Big Pharma makes sense to me, since one of the things I liked about doing research at Big Pharma (Merck, actually) was the critical mass of scientists and infrastructure which I find lacking at most (but not all) biotechs. And getting back to the goal of delivering-a-drug-eventually rather than delivering-a-candidate-by-November that might be allowed to flower (again) in such an environment - would be ... fun. And probably successful.

Derek, your argument, "pretty soon there'd be nothing for those whip-cracking revenue-maximizing managers to sell" is valid and miss an important point. Most if not all of the managers' main concern is the present profit margin or ROI, and the current shareholder's value. Since buy-and-hold is no longer a good investment strategy on the Wall street, why would the shareholders...and the CEOs care about something that may or may not happen in 5 years?

It would be healthier for the industry to split into the R&D, manufacturing and Sales/marketing fractions. At least the bean counters and the six sigmaers won't have to pretend they care about research....

I think you're right Derek. Not everyone can dump the R&D or there will be nothing for the Valeant's to acquire. As long as they pay fair value so investors in R&D get a good return and become inclined to invest again, it may be a better way of running a pharma company than Pfizer's never-ending mega-mergers, which do not appear to have been that great for the pipeline.

"..if you're only inlicensing, then no, there aren't so many other things for you to do with the money. Everyone else can look around the industry and see what's available for you to buy, and thus the price of your deals goes up."

This may be one of the saving graces of internal R&D expertise: That you have new insights that give you an advantage over Valaent-like models. I know of more than a few of the top firms that are investing in that "get the insight faster" capability. It benefits traditional Discovery, naturally. But the biggest advantage is in realizing the value of tech/patents/leads and acting (buying) before others are out of the gate. They can then get them at a lower price, and delay or block entry by slow starters.

Taken to conclusion, lean n' mean Big Pharma -- not much R/some D -- may find itself tending to overpay for the fruits of Small Co's R& small D. This is, if it's obvious to all that said Big Pharma is weak on ideas of its own, then Small Co can polish up its own Big Idea for sale at a premium. Whereupon the Illustrious Ones from said Big Pharma will get grumpy and decide it's time to reinvigorate internal R. And so the wheel turns again.

1) Culling the herd is necessary, but in nature it's the old and weak who are culled by the young and strong. With companies, it isn't the old and weak who are culled, but the young and (potentially) strong - the old and weakening are the cullers, not the culled.

2) At some point, even if you save internal R+D to some degree, if it never comes up with anything or hasn't the strength or morale to do anything useful, the bluffs will be unconvincing, and your ability to lower acquisition costs nonexistent.

3) Maybe I'm too cynical and/or liberal, but I wonder if Valeant's upper mgmt. has the same compensation scheme? At -$1/share, they shouldn't have done too well, were that the case. I am predisposed to believe they made out just fine...

Biology metaphores applied to management never go very far. Simply, economy is not biology. For example, if Valeant is a predator, then we can consider also the parasite/host roles or the symbiosis concept. Somebody told me that a parasitic relationship is in fact a symbiotic relationship going bad...

To summarize: predators need a big group of preys to survive and a parasite is harming its host.

This reminds me of the situation from when I joined Pharma in the 1970's. The front office guys (leaders) felt that R&D was unmanageable and a waste of monies better spent on Sales & Marketing - which was the "strength of the firm". Kicked around spinning off R&D - And this was THIRTY-FIVE YEARS AGO. McKinsey must be rerunning their old Super-8 film stocks...

Pearson has a strategy for Valeant, not for the whole Pharmaceutical industry. He is not licensing / acquiring products for free, he is ready to pay for them (and pay reasonable bucks as indicated by the decent premium offered for Cephalon). Also, his strategy is not new - spec pharma companies have been doing this for quite some time. They are not researchers. They are developers and commercializers. Valeant was never known for cutting edge research - he realized that when he took over and concentrated on what he felt the organization was better at (driving growth inorganically).

There is absolutely nothing wrong in segmenting our industry - the researchers, the developers, the commercializers. We do not HAVE TO BE fully integrated. An ecosystem where the researchers can out-license / get acquired by the developers, and the developers can out-license / get acquired by the commercializers would actually work well for all constituents.

"But my first thought (and the first thought of many of you, no doubt) is that it's making money because other people are willing to do the R&D that they themselves are taking a pass on."

True of course. The R&D business and sales business are very different entities. Specializing in one or the other can make a great deal of sense. Big pharma will never fully give up R&D, because the skill set to evaluate the R&D of others is necessary to the in licensing business function (there are the tax considerations too). The move toward acquiring or partnering with 'biotech' is just such a move in this direction.

I think you also need to split R&D. There is discovery R&D and clinical R&D, with the latter being the far more costly and lengthy process. Many a biotech has generated a good set of clinical candidates then 'fired the chemists' to focus on the clinic. They often have to do just that, as they don't have the resources for 'more candidates'. The pure play 'discovery shop' has never really gained traction though, probably due to the specialty required within each indication / target group. Accepting being mobil is a reality for early stage researchers. And don't get too excited about those stock options unless you are a late stage clinical researcher, the chemists and molecular biologists will likely not be around for the potential payoff.

"Lets not forget that internal R&D is good for evaluating potential buys as well." Really? Do we have evidence to support this view? Or do we just want to believe it?

From 1990 to 2005 we have witnessed the increase of R&D funding and manpower in internal R&D, at the same time the increase of in-licensing and deal making. Yet we have not seen any increase of drug output during that period. It seems based on the historical data one should argue the influence/benefit of internal R&D to in-licensing is minimum at best.

The problem I see is that we still don't know how to quantify the value of research and early development. This idea of splitting the industry (as if one had the power, but that's another story) into these two pieces was basically the investment view in the 90s when biotechs were either a "drug discovery company" or a "just a tool company". Back then, the "just" was definitely an indicator of second-class status in terms of intellectual respectability and financial expectations. Most new biotech's fought hard NOT to be seen by investors as "just a tool company", which helped earn them the reputation of being low value propositions.

In the scenario presented here, "hits" or "leads" or "candidates" would be thrown into the tool box, but I don't think we have any better idea of how to assign value to the new set of tools. The challenge is that, at the early stages, research moves forward by failing. What financial modeling views as "failing" is critical to success in the scientific method: you keep finding out what isn't the truth until you find something that you can't say isn't the truth and you accept that as true until some smartass (say a Galileo or an Einstein) finds the weakness. This "succeeding by failing", which is so essential to research, doesn't seem to jive well with financial methods like NPV calculations, which depend on a highly directional, ratchet-like progression of one step forward after another. We're convinced that our financial modeling allows us to make highly rational decisions, but then we still do the calculations irrationally (i.e. we kill the "Black Swans" by making certain assumptions) and behave irrationally when the reality, unsurprisngly, does not behave according to the calculations.

That's the philosophical part. The practical part of me looks at newer enterprises like Enlight Biosciences and sees that as a fresh new experiment in creating that first kind of company, specializing in the front end. One thing I like about Enlight's model is that it isn't entirely funded by stand-alone VCs, but rather by a consortium of the potential customers of the output of Enlight's component companies. To my mind, this makes the investors much more vested in the product of the company rather than just being interested in the monetary profit in a 5 year horizon. I would like to believe that that would lead to better product quality coming out of the front end of the discovery process. Do others view Enlight as an example of a new way of building up a stand-alone discovery industry such as the one envisioned in the piece Derek wrote?

Several posters have stated that you need internal R&D to evaluate in-licensing candidates - and one poster even stated without this "check and balance" there would be more Sirtis deals.

Didn't the Sirtis deal happen to a company with an internal R&D group? Yes.

Simple fact, internal R&D or not, if a upper-management person wants to make the deal, it will be made - I've seen it happen first hand. In theory, everyone is correct, internal R&D should provide the insight and it should be adhered to; but we all know that doesn't always happen.

Canâ€™t wait for the split of R&D from sales and marketing! Itâ€™s always embarrassing for real researchers to be associated with these silly TV commercials for prescription drugs. These ads are absolutely pathetic and insulting for the people who actually discover & develop the products.

I think most people are missing the big picture as to why R&D research for new medicines is vital.
From where I am standing, certain areas of R&D, for certain diseases should be nationalised (globalised?).

We already have the problem of new strains of bacteria, resistant to most antibiotics starting to thrive, and what is there on the pipeline of all the big pharmas to replace them? Even worst when entire teams of specialists in the field, summing have thousands of experience years, have been disposed of by companies.

There are things which we shouldn't, as a civilisation, try to put a price tag to.

Ricardo, #22,
I am with you in my heart, but my head says that we can't avoid the necessity of assigning a monetary value to things like research output. As I implied in a prior post, I think we are very bad at it, but the job must be done because accounting and finance, despite their problems dealing with the extreme uncertainty of drug discovery, are essential for any business transaction. We need to get better at assigning value, not give up trying to do it.

#18 Y: "one should argue the influence/benefit of internal R&D to in-licensing is minimum at best"

I disagree. Causality is always difficult. However, licensed drugs have rung up big sales; Plavix, Abilify, and Crestor all created huge sales (~ $18B in 2009) but not for the innovator alone. There are many more examples that are base-hits. Whether it was their R&D that pointed them to winners is difficult to prove, but those results will assure us in-licensing will continue, and firms will continue to try and make that process more successful.

I have a fundamental disagreement with extensive segmenting the various stages that are parts of a more fully integrated Pharma: introduction of more technology and knowledge transitions between different organizations and reduction of feedback loops to guide and avoid missteps. Tech transfer within the same company is usually a pain however normally have similar inherent terminologies and often know who knows what or makes decisions. Even the best of external relationships encounter many issues during project transfers, often because expectations and cultural variations. R&D types like to think they can work in isolation to generate new drugs while Sales & Marketing give the impression that once they have the product then R&D does not matter (except perhaps to support new indications). If the goal is to make a profit perhaps this becomes a approach but unlikely to generate significant advances in new meds and certainly will be less efficient and more costly. Big Pharma does seem to have gone after profit first rather than products so may be broken and with Merck counter current sounding hopeful if not too late.

I also think companies need good in-house expertise to conduct proper due diligence on acquisition of in-licensed projects. Problems have occurred when either not correct reviewers utilized or worse any negative advice was ignored.

Yes, vaccines are a real advance for humanity, but I have read that there has not been enough research effort and money put forth for agriculture, food storage and efficient utilization. Eating enough is a more immediate need than avoiding disease, so there are problems higher up the food chain, so to speak.

CMCGuy - Extremely good points and well stated. As the emphasis on innovation surges, let's not abandon the progress we have made on standards, information integration and speed.

Having helped lead major joint, in-licensing projects in the past, I forgot your point that each new alliance requires defining common ground/process/rules - even terminology, to avoid the feedback loops you cite. Integrated Pharma has indeed created some efficiency advantages. Now if we can only apply those collaborative "schmarts".

"From 1990 to 2005 we have witnessed the increase of R&D funding and manpower in internal R&D, at the same time the increase of in-licensing and deal making. Yet we have not seen any increase of drug output during that period. It seems based on the historical data one should argue the influence/benefit of internal R&D to in-licensing is minimum at best."

Thats the kind of broad strokes that outsiders love to pull. Are you a consultant? 15 years of drug discovery is not long in the pharma world, 1.5 product development cycles.

I would chalk that up to a lot of waste, expansion and upheaval combi-chem cha cha anyone. In addition to overly ambitious targets and goals that led to many clinical failures, while Pharma was raking in the sales.

One answer is a feebate. Since we can't accurately value research, put a massive tax break on R&D up to 25% of net income, paid for by an equal tax on gross drug revenues. Large pharma can still elect to forgo in-house research via contracts, but up to 25% becomes "free" for accounting purposes. Pure R&D companies will be no worse off, since they generate little or no direct drug revenue.

No one should expect spending to continue without short-term results. Just look at the early oil companies: they'd hire chemistry professors to solve a particular problem ("remove sulfur from Lima oil") and then return to a 0% R&D budget. They were throwing away enormous value in their unused refinery byproducts, but it took decades of waste before Standard Oil added permanent research staff.

The Party Officials would like to thank Mr. Lowe for being such an outstanding therapist. The simple fact that the words "Federal Reserve System" draws a complete blank in the pitiful minds of these grand idiots called scientists is, of course, the primary objective.

What really struck me is all the private equity guys they have on the board. My guess theyâ€™ll then load her up with debt, extract all the value as cash, pass her around a bit pumping up the price along with her balance sheet each time. Then try to fob the dyeing hulk of a company on to some suckers while they make off to â€œhelpâ€ new companies. They arenâ€™t planning for their future because there isnâ€™t going to be a future for Valeant.

I'm with the "biologist". If Valeant succeeds in taking over Cepahlon, their debt ratio will have to exceed 4:1 and there is absolutely no reason in their history to suggest that they would have any chance to overcome that.

The Valeant board are opportunists preying on the weak spots in our current health system but in a decade, no one will remember them.

The problem with the divergence into distinct commercial and R&D 'industries' is that in a wired world, the value of the capabilities of the commercial organization is diminishing steadily over time.

True consumerism in health care will entail greater price sensitivity to pricing which is set by professional/non-consumer gatekeepers. None of this bodes well for the current big pharma view of consumerism which has essentially been, in essence, generating demand for still relatively price insensitive brands.

It is like the stock market. When there are more buyers than sellers, value of your merchandise goes up. Imagine, if you are the last firm doing drug R&D, you are the monopoly, you can charge whatever you want. But way before that point, when supply

Rest of my comments got truncated in the previous post. Here is the rest.

It is like the stock market. When there are more buyers than sellers, value of your merchandise goes up. Imagine, if you are the last firm doing drug R&D, you are the monopoly, you can charge whatever you want. BTW before that point, when the supply is in severe shortage, vc and other investors will jump in and throw pretty penny at R&D firms with a hope to make monopoly-type of money. Market efficiency (& herd mentality) - capitalism at its best. MBA suits might not care about R&D, but they do care about money. There will be money made when there are more Valeants of the world than Genenetechs of the world.

...dont forget 1997 was a 'open the floodgates' year, that one time peak, coupled with stiffening regulatory environment each year since means that even treading water is a significant accomplishmen for the industry.

I mean, we don't want to Jim to go without a bonus because we don't want to "lose talent". 10 years from now the "good guys" will be those that are "conservative" and keep an emphasis on making their own products.

Nature is the house, and most times you will lose. The betting is still fun.

Yeah, but we're always betting against Nature - we exist after all. R+D is an attempt to improve the odds - sometimes it fails, and we've spent resources for no gain. Other times, we win, and eventually everybody wins (I hope).

The universe may be a casino, but unlike the ones we have, it doesn't eject card counters (at least I don't think it does).

@fishyfish is right
When the industry's autophagy binge reaches the point when only a few innovators are left making new drugs, why would those companies remain content as only discovery houses? Sure they may need to sell a couple projects early on to grow, but if they're really innovative there is an infinite supply of new projects. It's all about timing, cash flow and dancing with dinosaurs without getting stepped on. Companies always have the choice to stay independent, unless they run out of cash or their investors choose to sell. If they're strong enough they end up buying distribution channels or setting the royalty rate high enough that the distribution channels become low margin walmarts. The natural division is between R&D and sales/distribution not between R and Development/sales/distribution.

Dont forget that Valeant's strategy is only effective because they can borrow money cheaply thanks to the Fed easy money policies. Once these go away, it will become a tougher strategy to execute. Even if it still costs $1 billion to bring a drug to market that is still cheaper then what it costs to continue to buy companies.

I think that some companies are run almost exclusively to cater to market analysts. Their priorities are not in creating lasting value, but rather in quarterly profits and stock price.

This strategy could only work for around 10 years. The current industry contraction started before the recession, in the early to mid 2000's. A contraction implies excessive capacity relative to profits. Hence, Valeant has somewhat of a buyer's market. As others have stated, once the industry has equilibrated, then there will be a better balance of profits to numbers of companies/people. Once this equilibrium is acheived, then the prices of simply buying drugs will be very expensive.

Two possiblities could occur for Valeant in 10 years: 1) Valeant could buy some drug that makes them hugely successful and they can continue buying other's products or 2) Valeant buys some drugs that are not profitable enough to allow them to buy more drugs once the industry stops contracting. They are betting that they can pick out good drugs to buy. They have a couple years to buy good drugs, then they will be priced out.